Acctg-cycle.docx

Chart of Accounts Example Gray Electronic Repair Services Chart of Accounts ASSETS (1000-1999) 1000

Cash

1010

Accounts Receivable

1011

Allowance for Doubtful Accounts

1020

Notes Receivable

1030

Interest Receivable

1040

Service Supplies

1510

Leasehold Improvements

1520

Furniture and Fixtures

1521

Accumulated Depreciation – Furniture and Fixtures

1530

Service Equipment

1531

Accumulated Depreciation – Service Equipment

LIABILITIES (2000-2999) 2000

Accounts Payable

2010

Notes Payable

2020

Salaries Payable

2030

Rent Payable

2040

Interest Payable

2050

Unearned Revenue

2060

Loans Payable

OWNER'S EQUITY (3000-3999) 3000

Mr. Gray, Capital

3010

Mr. Gray, Drawing

REVENUES (4000-4999) 4000

Service Revenue

4010

Interest Income

4020

Gain on Sale of Equipment

4999

Income Summary

EXPENSES (5000-5999) 5000

Rent Expense

5010

Salaries Expense

5020

Supplies Expense

5030

Utilities Expense

5040

Interest Expense

5050

Taxes and Licenses

5060

Depreciation Expense

5070

Doubtful Accounts Expense

Additional accounts can be added as the need arises. For bigger companies, the accounts may be divided into several sub-accounts. For example, employee salaries may have various accounts for different departments and be included in the chart of accounts as: 5011 Salaries Expense – Administrative, 5012 Salaries Expense – Servicing, 5013 Salaries Expense – Marketing, etc. Again, take note that the chart of accounts of one company may not be suitable for another company. It all depends upon the company's needs. In any case, the chart of accounts is a useful tool for bookkeepers in recording business transactions.

JOURNAL ENTRY Transaction #1: On December 1, 2017, Mr. Donald Gray started Gray Electronic Repair Services by investing $10,000. The journal entry should increase the company's Cash, and increase (establish) the capital account of Mr. Gray; hence: Date 2017

Particulars

Dec 1 Cash

Debit

Credit

10,000.00

Mr. Gray, Capital

10,000.00

Transaction #2: On December 5, Gray Electronic Repair Services paid registration and licensing fees for the business, $370. First, we will debit the expense (to increase an expense, you debit it); and then, credit Cash to record the decrease in cash as a result of the payment. 5 Taxes and Licenses

370.00

Cash

370.00

Transaction #3: On December 6, the company acquired tables, chairs, shelves, and other fixtures for a total of $3,000. The entire amount was paid in cash. There is an increase in an asset account (Furniture and Fixtures) in exchange for a decrease in another asset (Cash). 6 Furniture and Fixtures Cash

3,000.00 3,000.00

Transaction #4: On December 7, the company acquired service equipment for $16,000. The company paid a 50% down payment and the balance will be paid after 60 days.

This

will

result

an asset account

in

a

compound

(debitService

journal

entry.

Equipment,

There $16,000),

is

an increase in a decrease in

another asset (credit Cash, $8,000, the amount paid), and an increase in a liability account (credit Accounts Payable, $8,000, the balance to be paid after 60 days). 7 Service Equipment

16,000.00

Cash

8,000.00

Accounts Payable

8,000.00

Transaction #5: Also on December 7, Gray Electronic Repair Services purchased service supplies on account amounting to $1,500. The company received supplies thus we will record a debit to increase supplies. By the terms "on account", it means that the amount has not yet been paid; and so, it is recorded as a liability of the company. 7 Service Supplies

1,500.00

Accounts Payable

1,500.00

Transaction #6: On December 9, the company received $1,900 for services rendered. We will then record an increase in cash (debit the cash account) and increase in income (credit the income account). 9 Cash Service Revenue

1,900.00 1,900.00

Transaction #7: On December 12, the company rendered services on account, $4,250.00. As per agreement with the customer, the amount is to be collected after 10 days. Under the accrual basis of accounting, income is recorded when earned.

In this transaction, the services have been fully rendered (meaning, we made an income; we just haven't collected it yet.) Hence, we record an increase in income and an increase in a receivable account. 12 Accounts Receivable

4,250.00

Service Revenue

4,250.00

Transaction #8: On December 14, Mr. Gray invested an additional $3,200.00 into the business. The entry would be similar to what we did in transaction #1, i.e. increase cash and increase the capital account of the owner. 14 Cash

3,200.00

Mr. Gray, Capital

3,200.00

Transaction #9: Rendered services to a big corporation on December 15. As per agreement, the $3,400 amount due will be collected after 30 days. 15 Accounts Receivable

3,400.00

Service Revenue

3,400.00

Transaction #10: On December 22, the company collected from the customer in transaction #7. We will record an increase in cash by debiting it. Then, we will credit accounts receivable to decrease it. We are reducing the receivable since it has already been collected. 17 Cash Accounts Receivable

4,250.00 4,250.00

Actually, we simply transferred the amount from receivable to cash in the above entry.

Transaction #11: On December 23, the company paid some of its liability in transaction #5 by issuing a check. The company paid $500 of the $1,500 payable. To record this transaction, we will debit Accounts Payable for $500 to decrease it by the said amount. Then, we will credit cash to decrease it as a result of the payment. The entry would be: 20 Accounts Payable

500.00

Cash

500.00

Accounts payable would now have a credit balance of $1,000 ($1,500 initial credit in transaction #5 less $500 debit in the above transaction). Transaction #12: On December 25, the owner withdrew cash due to an emergency need. Mr. Gray withdrew $7,000 from the company. We will decrease Cash since the company paid Mr. Gray $7,000. And, we will record withdrawals by debiting the withdrawal account – Mr. Gray, Drawings. 25 Mr. Gray, Drawings

7,000.00

Cash

7,000.00

Transaction # 13: On December 29, the company paid rent for December, $ 1,500. Again, we will record the expense by debiting it and decrease cash by crediting it. 29 Rent Expense Cash

1,500.00 1,500.00

Transaction #14: On December 30, the company acquired a $12,000 short-term bank loan; the entire amount plus a 10% interest is payable after 1 year. Again, the company received cash so we increase it by debiting Cash. The company now has a liability. We will record it by crediting the liability account – Loans Payable.

30 Cash

12,000.00

Loans Payable

12,000.00

Transaction #15: On December 31, the company paid salaries to its employees, $3,500. For this transaction, we will record/increase the expense account by debiting it and decrease cash by crediting it. (Note: This is a simplified entry to present the payment of salaries. In actual practice, different payroll accounting methods are applied.) 31 Salaries Expense

3,500.00

Cash

3,500.00

There you have it. You should be getting the hang of it by now. If not, then you can always go back to the examples above. Remember that accounting skills require mastery of concepts and practice.

POSTING The Posting Process Let us illustrate how accounting ledgers and the posting process work using the transactions we had in the previous lesson. Click here to see the journal entries we will be using. Take transaction #1 first. Date 2017

Particulars

Debit

Dec 1 Cash

Credit

10,000.00

Mr. Gray, Capital

10,000.00

Now, go to the ledger and find the accounts. Post the amounts debited and credited to the appropriate side. Debits go to the left and credits to the right. After posting the amounts, the cash and capital account would look like: Cash

Mr. Gray, Capital

10,000.00

10,000.00

Explanation: First, we posted the entry to Cash. Cash in the journal entry was debited so we placed the amount on the debit side (left side) of the account in the ledger. For Mr. Gray, Capital, it was credited so the amount is placed on the credit side (right side) of the account. And that's it. Posting is simply transferring the amounts from the journal to the respective accounts in the ledger. Note: The ledger accounts (or T-accounts) can also have fields for account number, description or particulars, and posting reference. Let's try to post the second transaction. 5 Taxes and Licenses Cash

370.00 370.00

After posting the above entry, the affected accounts in the ledger would look like these: Cash

Taxes and Licenses

10,000.00 370.00

370.00

There was a debit to Taxes and Licenses so we posted that in the left side (debit side) of the account. Cash was credited so we posted that on the right side of the account. Notice that after posting transaction #2, we now can get a more updated balance for each account. Cash now has a balance of $9,630 ($10,000 debit and 370 credit). Nice, right? Post all the other entries and we will be able to get the balances of all the accounts. General Ledger Example A general ledger contains accounts that are broad in nature such as Cash, Accounts Receivable, Supplies, and so on. There is another type of ledge which we call subsidiary ledger. It consists of accounts within accounts (i.e., specific accounts that make up a broad account). For example, Accounts Receivable may be made up of subsidiary accounts such as Accounts Receivable – Customer A, Accounts Receivable – Customer B, Accounts Receivable – Customer C, etc. Okay – let's go back to the general ledger. In the above discussion, we posted transactions #1 and #2 into the ledger. If we post all 15 transactions (click here to see the entries) and get the balances of each account at the end of the month, the ledger would look like this:

ASSETS

LIABILITES

CAPITAL

Cash

Accounts Payable

Mr. Gray, Capital

10,000.00

370.00

1,900.00

8,000.00

10,000.00

3,000.00

1,500.00

3,200.00

3,200.00

8,000.00

9,000.00

13,200.00

4,250.00

500.00

12,000.00

7,000.00 1,500.00

500.00

Loans Payable 12,000.00

Mr. Gray, Drawing 7,000.00

3,500.00 7,480.00 Service Revenue Accounts Receivable

1,900.00

4,250.00

4,250.00

4,250.00

3,400.00

3,400.00

3,400.00

9,550.00

Service Supplies

Rent Expense

1,500.00

1,500.00

Furniture and Fixtures

Salaries Expense

3,000.00

3,500.00

Service Equipment

Taxes and Licenses

16,000.00

370.00

After all accounts are posted, we can now derive the balances of each account. So how much Cash do we have at the end of the month? As shown in the ledger above, the company has $7,480 at the end of December. How about accounts receivable? Accounts payable? You can find them all in the ledger. Note: The above is a simplified and theoretical example of a ledger. In reality, companies have a lot more than 15 transactions! They may have hundreds or even thousands of transactions in one day. Imagine how lengthy the ledger would be. Worse, imagine the work needed in posting that many transactions manually. Because of technological advancements however, most accounting systems today perform automated posting process. Nonetheless, the above example shows how a ledger works.

TRIAL BALANCE To illustrate, here's a trial balance example. Based on the ledger we prepared in the previous lesson, the trial balance would look like this: Gray Electronic Repair Services Unadjusted Trial Balance December 31, 2017 Account Title

Debit

Cash

$

Accounts Receivable

3,400.00

Service Supplies

1,500.00

Furniture and Fixtures

3,000.00

Service Equipment

16,000.00

Credit

7,480.00

Accounts Payable

$

Loans Payable

12,000.00

Mr. Gray, Capital

13,200.00

Mr. Gray, Drawing

9,000.00

7,000.00

Service Revenue

9,550.00

Rent Expense

1,500.00

Salaries Expense

3,500.00

Taxes and Licenses

370.00

Totals

$ 43,750.00 $ 43,750.00

The purpose of the trial balance is to test the equality between total debits and total credits after the posting process. This trial balance is called an unadjusted trial balance (since adjustments are not yet included).

There are two other types of trial balance: the adjusted trial balance which is prepared after adjusting entries are prepared and posted, and the post-closing trial balance which is prepared after closing entries. These two are prepared in later steps of the accounting process. Equal Doesn't Always Mean Correct When the total debits and total credits are not equal, it is a clear indication that a mistake has been committed in the journalizing and/or posting process. An amount must have been entered incorrectly; hence, must be corrected. However, the trial balance does not guarantee that the records are accurate even if the total debits and total credits are equal. There are instances when this happens such as: when a transaction was not recorded or not posted (no debit and no credit), when a transaction was recorded or posted twice (total debits and total credits are both overstated by the same amount), when an account was recorded instead of another account of the same classification; for example, Supplies was debited instead of Equipment (the total debits would still be correct since they are both asset accounts).

CORRECTING ENTRIES A correcting entry is a journal entry whose purpose is to rectify the effect of an incorrect entry previously made. To illustrate how to prepare correcting entries, here are some examples. On December 5, 2017, Gray Electronic Repair Services paid $370 registration and licensing fees for the business. The correct entry is: Dec 5 Taxes and Licenses

370.00

Cash

370.00

Suppose the bookkeeper, for whatever reason, debited Transportation Expense instead of Taxes and Licenses. The entry made was: Dec 5 Transportation Expense Cash

370.00 370.00

Upon analysis, the Transportation Expense is overstated (higher than in should be) because the bookkeeper recorded transportation expense but it was not really a transportation expense. Also, Taxes and Licenses is understated (lower than it should be). The amount should have been recorded but was not recorded under this account. To correct these errors, we should make an entry to offset the effects. Transportation Expense is overstated therefore we should decrease it; Taxes and Licenses is understated therefore we should increase it.

The Cash account was credited in the entry made. Was the entry made to Cash correct? Look at the correct entry. Is it proper to have Cash credited? Yes. Therefore, we have no problem with the Cash account. Now, to increase Taxes and Licenses, we debit it. To decrease Transportation Expense, we credit it. Remember that to increase/record an expense, we debit it; to decrease an expense, we credit it. The correcting entry would then be: Dec 31 Taxes and Licenses

370.00

Transportation

370.00

Expense

Note: The correcting entry is dated when the error is discovered. In this case, we assumed that it was discovered and corrected on December 31. If an explanation or annotation is required, it would be something like: "To correct error made on taxes and licenses" or "To record correction of error on entry made for taxes and licenses." After making this entry, Transportation Expense will zero-out ($370 debit and $370 credit) and Taxes and Licenses will now have a balance of $370.00, thus making our records correct. Another Example Let us assume the bookkeeper made another error. On December 17, the company collected a receivable from a customer, $1,650.00. Suppose the bookkeeper recorded it at $1,560.00 instead of $1,650.00. This was the entry made:

Dec 17 Cash

1,560.00

Accounts Receivable

1,560.00

What is the correct entry? The entry should have been: Dec 17 Cash

1,650.00

Accounts Receivable

1,650.00

How will we correct this? Cash is understated because the accountant recorded $1,560 instead of $1,650. Accounts Receivable is also overstated because it was reduced by $1,560 only but should have been reduced by $1,650. We should then increase Cash and reduce Accounts Receivable by $90. The correcting entry would be:

Dec 31 Cash

90.00

Accounts Receivable

90.00

Another way of doing it (and an easier one) is to look at the entry made and correct entry. Upon analysis, you will see that the amount debited to Cash is less that what should have been debited. The same goes for the amount credited to Accounts Receivable. Cash should then be debited by $90 more and Accounts Receivable should be credited by $90 more. Recap: Steps in Making Correcting Entries The steps in preparing correcting entries may be summed up as follows: Determine the entry made. – What was the erroneous/wrong entry made? Determine the correct entry. – What entry should have been made? Analyze #1 and #2 to come up with the correcting entry.

Steps 1 and 2 may be interchanged. Nonetheless, you need to know the entry made and the correct entry (should-be entry) before you can come up with the correcting entry.

ADJUSTING ENTRY: ACCRUED INCOME Accrued income (or accrued revenue) refers to income already earned but has not yet been collected. At the end of every period, accountants should make sure that they are properly included as income, with a corresponding receivable. When a company has performed services or sold goods to a customer, it should be recognized as income even if the amount is still to be collected at a future date. If no journal entry was ever made for the above, then an adjusting entry is necessary. Pro-Forma Entry The adjusting entry to record an accrued revenue is: mmm dd Receivable account*

x,xxx.xx

Income account**

x,xxx.xx

*Appropriate receivable account such as Accounts Receivable, Rent Receivable, Interest Receivable, etc. **Income account such as Service Revenue, Rent Income, Interest Income, etc. Here's an Example In our previous set of transactions, assume this additional information: On December 31, 2017, Gray Electronic Repair Services rendered $300 worth of services to a client. However, the amount has not yet been collected. It was agreed that the customer will pay the amount on January 15, 2018. The transaction was not recorded in the books of the company as of 2017. In this case, we should make an adjusting entry in 2017 to recognize the income since it has already been earned. The adjusting entry would be: Dec 31 Accounts Receivable Service Revenue

300.00 300.00

Here are some more illustrations. More Examples: Adjusting Entries for Accrued Income

Example 1: Company ABC leases its building space to a tenant. The tenant agreed to pay monthly rental fees of $2,000 covering a period from the 1st to the 30th or 31st of every month. On December 31, 2017, ABC Company did not receive the rental fee for December yet and no record was made in the journal. Under the accrual basis, the rent income above should already be recognized because it has already been earned even if it has not yet been collected. The adjusting journal entry would be: Dec 31 Rent Receivable

2,000.00

Rent Income

2,000.00

Example 2: ABC Company lent $9,000 at 10% interest on December 1, 2017. The amount will be collected after 1 year. At the end of December, no entry was entered in the journal to take up the interest income. Interest is earned through the passage of time. In the case above, the $9,000 principal plus a $900 interest will be collected by the company after 1 year. The $900 interest pertains to 1 year. However, 1 month has already passed. The company is already entitled to 1/12 of the interest, as prorated. Therefore the adjusting entry would be to recognize $75 (i.e. $900 x 1/12 ) as interest income: Dec 31 Interest Receivable Interest Income

75.00 75.00

The basic concept you need to remember is recognition of income. When is income recognized? Under the accrual concept of accounting, income is recognized when earned regardless of when collected. If the company has already earned the right to it and no entry has been made in the journal, then an adjusting entry to record the income and a receivable is necessary.

ADJUSTING ENTRY: ACCRUED EXPENSE Pro-Forma Entry The pro-forma adjusting entry to record an accrued expense is: mmm dd Expense account*

x,xxx.xx

Liability account**

x,xxx.xx

*Appropriate expense account (such as Utilities Expense, Rent Expense, Interest Expense, etc.) **Appropriate liability account (Utilities Payable, Rent Payable, Interest Payable, Accounts Payable, etc.) For Example For the month of December 2017, Gray Electronic Repair Services used a total of $1,800 worth of electricity and water. The company received the bills on January 10, 2018. When should the expense be recorded, December 2017 or January 2018? Answer – in December 2017. According to the accrual concept of accounting, expenses are recognized when incurred regardless of when paid. The amount above pertains to utilities used in December. Therefore, if no entry was made for it in December then an adjusting entry is necessary. Dec 31 Utilities Expense Utilities Payable

1,800.00 1,800.00

In the adjusting entry above, Utilities Expense is debited to recognize the expense and Utilities Payable to record a liability since the amount is yet to be paid. Here are some more examples. More Examples: Adjusting Entries for Accrued Expense Example 1: VIRON Company entered into a rental agreement to use the premises of DON's building. The agreement states that VIRON will pay monthly rentals of $1,500. The lease started on December 1, 2017. On December 31 of

the same year, the rent for the month has not yet been paid and no record for rent expense was made. In this case, VIRON Company already incurred (consumed/used) the expense. Even if it has not yet been paid, it should be recorded as an expense. The necessary adjusting entry would be: Dec 31 Rent Expense

1,500.00

Rent Payable

1,500.00

Example 2: VIRON Company borrowed $6,000 at 12% interest on August 1, 2017. The amount will be paid after 1 year. At the end of December, the end of the accounting period, no entry was entered in the journal to take up the interest. Let's analyze the above transaction. VIRON will be paying $6,000 principal plus $720 interest after a year. The $720 interest covers 1 year. At the end of December, a part of that is already incurred, i.e. $720 x 5/12 or $300. That pertains to interest for 5 months, from August 1 to December 31. The adjusting entry would be: Dec 31 Interest Expense Interest Payable

300.00 300.00

Expenses are recognized when incurred regardless of when paid. What you need to remember here is this: when it has been consumed or used and no entry was made to record the expense, then there is a need for an adjusting entry.

ADJUSTING ENTRY: UNEARNED REVENUE There are two ways of recording unearned revenue: (1) the liability method, and (2) the income method. Liability Method of Recording Unearned Revenue Under the liability method, a liability account is recorded when the amount is collected. The common accounts used are: Unearned Revenue, Deferred Income, Advances from Customers, etc. For this illustration, let us use Unearned Revenue. Suppose on January 10, 2017, ABC Company made $30,000 advanced collections from its customers. If the liability method is used, the entry would be: Jan 10 Cash

30,000.00

Unearned Revenue

30,000.00

Take note that the amount has not yet been earned, thus it is proper to record it as a liability. Now, what if at the end of the month, 20% of the unearned revenue has been rendered? This will require an adjusting entry. The adjusting entry will include: (1) recognition of $6,000 income, i.e. 20% of $30,000, and (2) decrease in liability (unearned revenue) since some of it has already been rendered. The adjusting entry would be: Jan 31 Unearned Revenue Service Income

6,000.00 6,000.00

We are simply separating the earned part from the unearned portion. Of the $30,000 unearned revenue, $6,000 is recognized as income. In the entry above,

we removed $6,000 from the $30,000 liability. The balance of unearned revenue is now at $24,000. Income Method of Recording Unearned Revenue Under the income method, the accountant records the entire collection under an incomeaccount. Using the same transaction above, the initial entry for the collection would be: Jan 10 Cash

30,000.00

Service Income

30,000.00

If at the end of the year the company earned 20% of the entire $30,000, then the adjusting entry would be: Jan 31 Service Income

24,000.00

Unearned Income

24,000.00

By debiting Service Income for $24,000, we are decreasing the income initially recorded. The balance of Service Income is now $6,000 ($30,000 - 24,000), which is actually the 20% portion already earned. By crediting Unearned Income, we are recording a liability for $24,000. Notice that the resulting balances of the accounts under the two methods are the same (Cash: $30,000; Service Income: $6,000; and Unearned Income: $24,000). Another Example On December 1, 2017, DRG Company collected from TRM Corp. a total of $60,000 as rental fee for three months starting December 1. Under the liability method, the initial entry would be: Dec 1 Cash Unearned Rent Income

60,000.00 60,000.00

On December 31, 2017, the end of the accounting period, 1/3 of the rent received has already been earned (prorated over 3 months).

We should then record the income through this adjusting entry: Dec 31 Unearned Rent Income

20,000.00

Rent Income

20,000.00

In effect, we are transferring $20,000, one-third of $60,000, from the Unearned Rent Income (a liability) to Rent Income (an income account) since that portion has already been earned. If the company made use of the income method, the initial entry would be: Dec 1 Cash

60,000.00

Rent Income

60,000.00

In this case, we must decrease Rent Income by $40,000 because that part has not yet been earned. The income account shall have a balance of $20,000. The amount removed from income shall be transferred to liability (Unearned Rent Income). The adjusting entry would be: Dec 31 Rent Income Unearned Rent Income

40,000.00 40,000.00

Conclusion If you have noticed, what we are actually doing here is making sure that the earned part is included in income and the unearned part into liability. The adjusting entry will always depend upon the method used when the initial entry was made.

If you are having a hard time understanding this topic, I suggest you go over and study the lesson again. Sometimes, it really takes a while to get the concept. Preparing adjusting entries is one of the most challenging (but important) topics for beginners.

ADJUSTING ENTRY: PREPAID EXPENSE There are two ways of recording prepayments: (1) the asset method, and (2) the expense method. Asset Method Under the asset method, a prepaid expense account (an asset) is recorded when the amount is paid. Prepaid expense accounts include: Office Supplies, Prepaid Rent, Prepaid Insurance, and others. In one of our previous illustrations (if you have been following our comprehensive illustration for Gray Electronic Repair Services), we made this entry to record the purchase of service supplies: Dec 7 Service Supplies Cash

1,500.00 1,500.00

Take note that the amount has not yet been incurred, thus it is proper to record it as an asset. Suppose at the end of the month, 60% of the supplies have been used. Thus, out of the $1,500, $900 worth of supplies have been used and $600 remain unused. The $900 must then be recognized as expense since it has already been used.

In preparing the adjusting entry, our goal is to transfer the used part from the asset initially recorded into expense – for us to arrive at the proper balances shown in the illustration above.

The adjusting entry will include: (1) recognition of expense and (2) decrease in the asset initially recorded (since some of it has already been used). The adjusting entry would be: Dec 31 Service Supplies Expense

900.00

Service Supplies

900.00

The "Service Supplies Expense" is an expense account while "Service Supplies" is an asset. After making the entry, the balance of the unused Service Supplies is now at $600 ($1,500 debit and $900 credit). Service Supplies Expense now has a balance of $900. Now, we've achieved our goal. Expense Method Under the expense method, the accountant initially records the entire payment as expense. If the expense method was used, the entry would have been: Dec 7 Service Supplies Expense

1,500.00

Cash

1,500.00

Take note that the entire amount was initially expensed. If 60% was used, then the adjusting entry at the end of the month would be: Dec 31 Service Supplies

600.00

Service Supplies Expense

600.00

This time, Service Supplies is debited for $600 (the unused portion). And then, Service Supplies Expense is credited thus decreasing its balance. Service Supplies Expense is now at $900 ($1,500 debit and $600 credit). Notice that the resulting balances of the accounts under the two methods are the same (Cash paid: $1,500; Service Supplies Expense: $900; and Service Supplies: $600). Another Example GVG Company acquired a six-month insurance coverage for its properties on September 1, 2017 for a total of $6,000. Under the asset method, the initial entry would be:

Sep 1 Prepaid Insurance

6,000.00

Cash

6,000.00

On December 31, 2017, the end of the accounting period, part of the prepaid insurance already has expired (hence, expense is incurred). The expired part is the insurance from September to December. Thus, we should make the following adjusting entry: Dec 31 Insurance Expense

4,000.00

Prepaid Insurance

4,000.00

Of the total six-month insurance amounting to $6,000 ($1,000 per month), the insurance for 4 months has already expired. In the entry above, we are actually transferring $4,000 from the asset to the expense account (i.e., from Prepaid Insurance to Insurance Expense).

If the company made use of the expense method, the initial entry would be: Sep 1 Insurance Expense Cash

6,000.00 6,000.00

In this case, we must decrease Insurance Expense by $2,000 because that part has not yet been incurred (not used/not expired). Insurance Expense shall then have a balance of $4,000. The amount removed from the expense shall be transferred to Prepaid Insurance. The adjusting entry would be: Dec 31 Prepaid Insurance Insurance Expense Conclusion

2,000.00 2,000.00

What we are actually doing here is making sure that the incurred (used/expired) portion is included in expense and the unused part into asset. The adjusting entry will always depend upon the method used when the initial entry was made. If you are having a hard time understanding this topic, I suggest you go over and study the lesson again. Sometimes, it really takes a while to get the concept. Preparing adjusting entries is one of the challenging (but important) topics for beginners.

ADJUSTING ENTRY: DEPRECIATION EXPENSE When a fixed asset is acquired by a company, it is recorded at cost (generally, cost is equal to the purchase price of the asset). This cost is recognized as an asset and not expense. The cost is to be allocated as expense to the periods in which the asset is used.This is done by recording depreciation expense. There are two types of depreciation – physical and functional depreciation. Physical depreciation results from wear and tear due to frequent use and/or exposure to elements like rain, sun and wind. Functional or economic depreciationhappens when an asset becomes inadequate for its purpose or becomes obsolete. In this case, the asset decreases in value even without any physical deterioration. Understanding the Concept of Depreciation There are several methods in depreciating fixed assets. The most common and simplest is the straight-line depreciation method. Under the straight line method, the cost of the fixed asset is distributed evenly over the life of the asset. For example, ABC Company acquired a delivery van for $40,000 at the beginning of 2012. Assume that the van can be used for 5 years. The entire amount of $40,000 shall be distributed over five years, hence a depreciation expense of $8,000 each year.

Straight-line depreciation expense is computed using this formula: Depreciable Cost – Residual Value Estimated Useful Life Depreciable Cost: Historical or un-depreciated cost of the fixed asset Residual Value or Scrap Value: Estimated value of the fixed asset at the end of its useful life Useful Life: Amount of time the fixed asset can be used (in months or years) In the above example, there is no residual value. Depreciation expense is computed as: = $40,000 – $0 5 years = $8,000 / year With Residual Value What if the delivery van has an estimated residual value of $10,000? The depreciation expense then would be computed as: = $40,000 – $10,000 5 years = $30,000 5 years = $6,000 / year

How to Record Depreciation Expense

Depreciation is recorded by debiting Depreciation Expense and crediting Accumulated Depreciation. This is recorded at the end of the period (usually, at the end of every month, quarter, or year). The entry to record the $6,000 depreciation every year would be: Dec 31 Depreciation Expense

6,000.00

Accumulated

6,000.00

Depreciation

Depreciation Expense: An expense account; hence, it is presented in the income statement. It is measured from period to period. In the illustration above, the depreciation expense is $6,000 for 2012, $6,000 for 2013, $6,000 for 2014, etc. Accumulated Depreciation: A balance sheet account that represents the accumulated balance of depreciation. It is continually measured; hence the accumulated depreciation balance is $6,000 at the end of 2012, $12,000 in 2013, $18,000 in 2014, $24,000 in 2015, and $30,000 in 2016. Accumulated depreciation is a contra-asset account. It is presented in the balance sheet as a deduction to the related fixed asset. Here's a table illustrating the computation of the carrying value of the delivery van. 2012 Delivery Van - Historical Cost

2014

2015

2016

$40,000 $40,000 $40,000 $40,000 $40,000

Less: Accumulated Depreciation 6,000 Delivery Van - Carrying Value

2013

12,000

18,000

24,000

30,000

$34,000 $28,000 $22,000 $16,000 $10,000

Notice that at the end of the useful life of the asset, the carrying value is equal to the residual value. Depreciation for Acquisitions Made Within the Period The delivery van in the example above has been acquired at the beginning of 2012, i.e. January. Therefore, it is easy to calculate for the annual straight-line depreciation. But what if the delivery van was acquired on April 1, 2012?

In this case we cannot apply the entire annual depreciation in the year 2012 because the van has been used only for 9 months (April to December). We need to prorate. For 2012, the depreciation expense would be: $6,000 x 9/12 = $4,500. Years 2013 to 2016 will have $6,000 annual depreciation expense. In 2017, the van will be used for 3 months only (January to March) since it has a useful life of 5 years (i.e. April 1, 2012 to March 31, 2017). The depreciation expense for 2017 would be: $6,000 x 3/12 = $1,500, and thus completing the accumulated depreciation of $30,000. 2012 (April to December)

$ 4,500

2013 (entire year)

6,000

2014 (entire year)

6,000

2015 (entire year)

6,000

2016 (entire year)

6,000

2017 (January to March) 1,500 Total for 5 years

$ 30,000

ADJUSTING ENTRY: BAD DEBTS Companies provide services or sell goods for cash or on credit. Allowing credit tends to encourage more sales. However, businesses that allow credit are faced with the risk that their receivables may not be collected. Accounts receivable should be presented in the balance sheet at net realizable value, i.e. the most probable amount that the company will be able to collect. Net realizable value for accounts receivable is computed like this: Accounts Receivable (Gross Amount)

$100,000

Less: Allowance for Bad Debts

3,000

Accounts Receivable (Net Realizable Value) $ 97,000 Allowance for Bad Debts (also often called Allowance for Doubtful Accounts) represents the estimated portion of the Accounts Receivable that the company will not be able to collect. Take note that this amount is an estimate. There are several methods in estimating doubtful accounts.The estimates are often based on the company's past experiences. To recognize doubtful accounts or bad debts, an adjusting entry must be made at the end of the period. The adjusting entry for bad debts looks like this: Dec 31 Bad Debts Expense Allowance for Bad Debts

xxx.xx xxx.xx

Bad Debts Expense a.k.a. Doubtful Accounts Expense: An expense account; hence, it is presented in the income statement. It represents the estimated uncollectible amount for credit sales/revenues made during the period. Allowance for Bad Debts a.k.a. Allowance for Doubtful Accounts: A balance sheet account that represents the total estimated amount that the company will not be able to collect from its total Accounts Receivable.

What is the difference between Bad Debts Expense and Allowance for Bad Debts? Bad Debts Expense is an income statement account while the latter is a balance sheet account. Bad Debts Expense represents the uncollectible amount for credit sales made during the period. Allowance for Bad Debts, on the other hand, is the uncollectible portion of the entire Accounts Receivable. You can also use Doubtful Accounts Expense and Allowance for Doubtful Accounts in lieu of Bad Debts Expense and Allowance for Bad Debts. However, it is a good practice to use a uniform pair. Some say that Bad Debts have a higher degree of uncollectibility that Doubtful Accounts. In actual practice, however, the distinction is not really significant. Here's an Example Gray Electronic Repair Services estimates that $100.00 of its credit revenue for the period will not be collected. The entry at the end of the period would be: Dec 31 Bad Debts Expense

100.00

Allowance for Bad

100.00

Debts

Again, you may use Doubtful Accounts. Just be sure to use a logical (and uniform) pair every time. For example: Dec 31

Doubtful Accounts Expense

100.00

Allowance for Doubtful Accounts

100.00

If the company's Accounts Receivable amounts to $3,400 and its Allowance for Bad Debts is $100, then the Accounts Receivable shall be presented in the balance sheet at $3,300 – the net realizable value. Accounts Receivable (Gross Amount)

$ 3,400

Less: Allowance for Bad Debts

100

Accounts Receivable - Net Realizable Value $ 3,300

ADJUSTED TRIAL BALANCE

An adjusted trial balance is prepared after adjusting entries are made and posted to the ledger. This is the second trial balance prepared in the accounting cycle. Its purpose is to test the equality between debits and credits after adjusting entries are entered into the books of the company. To illustrate how it works, here is a sample unadjusted trial balance:

Gray Electronic Repair Services Unadjusted Trial Balance December 31, 2017

Account Title Cash

Debit $ 7,480.00

Accounts Receivable

3,400.00

Service Supplies

1,500.00

Furniture and Fixtures

3,000.00

Service Equipment

Credit

16,000.00

Accounts Payable

$ 9,000.00

Loans Payable

12,000.00

Mr. Gray, Capital

13,200.00

Mr. Gray, Drawing

7,000.00

Service Revenue

9,550.00

Rent Expense

1,500.00

Salaries Expense

3,500.00

Taxes and Licenses Totals

370.00 $ 43,750.00

$ 43,750.00

At the end of the period, the following adjusting entries were made: Dec 31 Accounts Receivable

300.00

Service Revenue

31 Utilities Expense

300.00

1,800.00

Utilities Payable

31 Service Supplies Expense

1,800.00

900.00

Service Supplies

31 Depreciation Expense Accumulated Depreciation

900.00

720.00 720.00

After posting the above entries, the values of some of the items in the unadjusted trial balancewill change. Take the first adjusting entry. Accounts Receivable is debited hence is increased by $300. Service Revenue is credited for $300. The balance of Accounts Receivable is increased to $3,700, i.e. $3,400 unadjusted balance plus $300 adjustment. Service Revenue will now be $9,850 from the unadjusted balance of $9,550. Next entry. Utilities Expense and Utilities Payable did not have any balance in the unadjusted trial balance. After posting the above entries, they will now appear in the adjusted trial balance. Third. Service Supplies Expense is debited for $900. Service Supplies is credited for $900. The Service Supplies account had a debit balance of $1,500. After incorporating the $900 credit adjustment, the balance will now be $600 (debit). And fourth. There were no Depreciation Expense and Accumulated Depreciation in the unadjusted trial balance. Because of the adjusting entry, they will now have a balance of $720 in the adjusted trial balance.

Adjusted Trial Balance Example After incorporating the adjustments above, the adjusted trial balance would look like this. Just like in the unadjusted trial balance, total debits and total credits should be equal.

Gray Electronic Repair Services Adjusted Trial Balance December 31, 2017

Account Title Cash Accounts Receivable Service Supplies Furniture and Fixtures Service Equipment

Debit

Credit

$ 7,480.00 3,700.00 600.00 3,000.00 16,000.00

Accumulated Depreciation

$

720.00

Accounts Payable

9,000.00

Utilities Payable

1,800.00

Loans Payable

12,000.00

Mr. Gray, Capital

13,200.00

Mr. Gray, Drawing

7,000.00

Service Revenue

9,850.00

Rent Expense

1,500.00

Salaries Expense

3,500.00

Taxes and Licenses Utilities Expense

370.00 1,800.00

Service Supplies Expense

900.00

Depreciation Expense

720.00

Totals

$ 46,570.00

$ 46,570.00

IS Net income is equal to total revenues minus total expenses. Gray Electronic Repair Services Income Statement For the Year Ended December 31, 2017 Service Revenue $ 9,850 Less: Operating Expenses Salaries Expense $ 3,500 Utilities Expense 1,800 Rent Expense 1,500 Service Supplies Expense 900 Depreciation Expense 720 Taxes and Licences 370 8,790 Net Income $ 1,060 Again, we drew a single line under 8,790 to indicate that a mathematical operation was made. Two horizontal lines are drawn under the final amount (1,060 net income). This is known as "double-rule" and is similar to enclosing the final answers in a box or circle in your math test. So there you go. The preparation is somewhat easy – you just need to be familiar with the different revenue and expense accounts.

OE Compute for the balance of the capital account at the end of the period and draw the lines. One horizontal line means that a mathematical operation has been performed. Two horizontal lines (double-rule) are drawn below the final amount. Gray Electronic Repair Services Statement of Changes in Owner's Equity For the Year Ended December 31, 2017 Gray, Capital - beginning Add: Additional Contributions Net Income Less: Gray, Drawings Gray, Capital - ending

$ 0 13,200 1,060 7,000 $ 7,260

Conclusion So there you have the preparation of a Statement of Changes in Owner's Equity. It is a report that shows the items that affect the capital or equity account. Simply, we are just presenting this formula in a formal report: Capital, ending = Capital, beg. + Additional Contributions + Net Income Withdrawals where: Net Income = Income - Expenses

BS Gray Electronic Repair Services Balance Sheet As of December 31, 2017 ASSETS Current Assets: Cash $ 7,480 Accounts Receivable 3,700 Service Supplies 600 Total Current Assets Non-Current Assets: Furniture and Fixtures $ 3,000 Service Equipment 16,000 Less: Accumulated Depreciation 720 Total Non-Current Assets TOTAL ASSETS LIABILITIES AND CAPITAL Current Liabilities: Accounts Payable Utilities Payable Total Current Liabilities Non-Current Liabilities: Loans Payable Total Non-Current Liabilities Total Liabilities Gray, Capital - ending TOTAL LIABILITIES AND CAPITAL

11,780

18,280 $ 30,060

9,000 1,800 10,800 12,000 12,000 22,800 7,260 $ 30,060

Total assets should be equal to total liabilities and capital. If they are not, then something must have gone wrong during the process. There you have it. The balance sheet we have just prepared is for a sole proprietorship business. In a partnership, several capital accounts will have to be presented – one for each partner. In a corporation, the capital portion is known as stockholders' equity and is made up of capital stock, reserves, and retained earnings.

CLOSING ENTRIES Step 1: Close all income accounts to Income Summary Date 2017

Particulars

Dec 31 Service Revenue

Debit

Credit

9,850.00

Income Summary

9,850.00

In the given data, there is only 1 income account, i.e. Service Revenue. It has a credit balance of $9,850. To close that, we debit Service Revenue for the full amount and credit Income Summary for the same. The Income Summary account is temporary. It is used to close income and expenses. As you will see later, Income Summary is eventually closed to capital. Step 2: Close all expense accounts to Income Summary 31 Income Summary

8,790.00

Rent Expense

1,500.00

Salaries Expense

3,500.00

Taxes and Licenses

370.00

Utilities Expense

1,800.00

Service Supplies Expense Depreciation Expense

900.00 720.00

To close expenses, we credit the expense accounts and debit Income Summary. Now for the next step, we need to get the balance of the Income Summary account. In step 1, we credited it for $9,850 and debited it in step 2 for $8,790. It would then have a credit balance of $1,060. Notice that the balance of the Income Summary account is actually the net income for the period. Remember that net income is equal to all income minus all expenses.

Step 3: Close Income Summary to the appropriate capital account The Income Summary balance is ultimately closed to the capital account. 31 Income Summary

1,060.00

Mr. Gray, Capital

1,060.00

Step 4: Close withdrawals to the capital account Note: This step is applicable only to sole proprietorships and partnerships. In a sole proprietorship, a drawing account is maintained to record all withdrawals made by the owner. In a partnership, a drawing account is maintained for each partner. Drawing accounts are closed to capital at the end of the accounting period. Our example is a sole proprietorship business. Mr. Gray's withdrawals are recorded in Mr. Gray, Drawing. To close the drawing account to the capital account, we credit the drawing account and debit the capital account. Notice that drawings decrease capital. 31 Mr. Gray, Capital

7,000.00

Mr. Gray, Drawing

7,000.00

Conclusion The purpose of closing entries is to prepare the temporary accounts for the next accounting period. In other words, the income and expense accounts are "restarted". After preparing the closing entries above, Service Revenue will now be zero. The expense accounts and withdrawal accounts will now also be zero. The balances of these accounts have been absorbed by the capital account – Mr. Gray, Capital, which now has a balance of $7,260 ($13,200 beginning balance + $1,060 in step #3 - $7,000 in step #4).

POST CLOSING TRIAL BALANCE Post-Closing Trial Balance Example After incorporating the closing entries above, the post-closing trial balance would look like this: Gray Electronic Repair Services Post-Closing Trial Balance December 31, 2017 Account Title Cash

Debit $

7,480.00

Accounts Receivable

3,700.00

Service Supplies

600.00

Furniture and Fixtures

3,000.00

Service Equipment

16,000.00

Accumulated Depreciation

Credit

$

720.00

Accounts Payable

9,000.00

Utilities Payable

1,800.00

Loans Payable

12,000.00

Mr. Gray, Capital

7,260.00

Totals

$ 30,780.00 $ 30,780.00

The balances of the nominal accounts (income, expense, and withdrawal accounts) have been absorbed by the capital account – Mr. Gray, Capital. Hence, you will not see any nominal account in the post-closing trial balance. And just like any other trial balance, total debits and total credits should be equal.

REVERSING The only types of adjusting entries that may be reversed are those that are prepared for the following: accrued income, accrued expense, unearned revenue using the income method, and prepaid expense using the expense method. Adjusting entries for unearned revenue under the liability methodand for prepaid expense under the asset method are never reversed. Adjusting entries for depreciation, bad debts and other allowances are also never reversed. Reversing Entry for Accrued Income Example: ABC Company is to receive $3,000 interest income at the end of February 2018. It covers 3 months starting December 1, 2017. At the end of 2017, the accountant properly made an adjusting entry for one month's worth of accrued income. Date 2017

Particulars

Dec 31 Interest Receivable

Debit

Credit

1,000.00

Interest Income

1,000.00

At the beginning of 2018, the accountant can prepare this reversing entry: Date 2018

Particulars

Jan 1 Interest Income Interest Receivable

Debit

Credit

1,000.00 1,000.00

The adjusting entry is simply reversed. Debit what was credited and credit what was debited. When the ABC Company receives the interest income at the end of February, the accountant will then prepare this journal entry:

Feb 28 Cash

3,000.00

Interest Income

3,000.00

Notice that Interest Income is credited for 3,000. Now you might be asking this: Under the concept of accrual, the interest income to be recognized in 2018 should be $2,000. Then why credit $3,000 Interest Income? Very good. Well, in the reversing entry at the beginning of the period, Interest Income was already debited for $1,000. So if we combine them ($1,000 debit and 3,000 credit), then we'll end up with $2,000 Interest Income which is the correct amount to be recognized in 2018. We said that reversing entries are optional. If the accountant did not make a reversing entry at the beginning of the year, the accountant will have this entry upon collection of the income. Feb 28 Cash

3,000.00

Interest Receivable

1,000.00

Interest Income

2,000.00

Note: Actually, if you combine the reversing entry and journal entry for collection. You'll come up with the journal entry above. Reversing Entry for Accrued Expense Example: Suppose that ABC Company and its lessor agrees that ABC will pay rent at the end of January 2018, covering a 3-month period starting November 1, 2017. The entire amount is $6,000. At the end of December 2017, the accountant properly prepared this adjusting entry for two months worth of rent expense (Nov 1 to Dec 31): Date 2017

Particulars

Dec 31 Rent Expense Rent Payable

Debit

Credit

4,000.00 4,000.00

At the beginning of 2018, the accountant can prepare this reversing entry:

Date 2018

Particulars

Jan 1 Rent Payable

Debit

Credit

4,000.00

Rent Expense

4,000.00

Again, notice that the adjusting entry is simply reversed. When the company pays the entire rent, the accountant will then prepare this journal entry: Jan 31 Rent Expense

6,000.00

Cash

6,000.00

In effect, Rent Expense for 2017 is $2,000 even if the accountant debits $6,000 upon payment. This is because of the reversing entry which includes a credit to Rent Expense for $4,000. If the accountant did not make a reversing entry at the beginning of the year, the accountant will have this entry upon payment of the rent. Jan 31 Rent Payable

4,000.00

Rent Expense

2,000.00

Cash

6,000.00

There you have the first two types of adjusting entries that can be reversed. If you are having trouble understanding the process, don't worry. It requires some time and a little effort for the concepts to sink in. In part 2, we'll take a look at the other two types. Reversing Entry for Unearned Income If the income method is used in recording unearned income, reversing entries can be prepared. Take note that adjusting entries for unearned income recorded using the liability method are never reversed.

Example: ABC Company recorded customer advances amounting to $5,000 in December 1, 2017. The company uses the income method in recording unearned income. Date 2017

Particulars

Debit

Dec 1 Cash

Credit

5,000.00

Service Revenue

5,000.00

At the end of 2017, the company rendered $2,000 worth of services. We need to set-up the unearned income of $3,000 and bring Service Revenue to its correct balance ($2,000). The adjusting entry would be: Dec 31 Service Revenue

3,000.00

Unearned Revenue

3,000.00

At the beginning of 2018, the following reversing entry can be prepared: Date 2018

Particulars

Jan 1 Unearned Revenue

Debit

Credit

3,000.00

Service Revenue

3,000.00

Notice that the adjusting entry is simple reversed. At the end of 2018, Service Revenue will again be checked to see if there is any unearned portion and if an adjusting entry is necessary. Reversing Entry for Prepaid Expense If the expense method is used in recording prepaid expense, reversing entries can be prepared. Adjusting entries for prepaid expense under the asset method are not reversed. Example: On December 1, 2017, ABC Company paid $7,500 of rent for 3 months starting December 1. The expense method was used in recording this transaction.

Date 2017

Particulars

Dec 1 Rent Expense

Debit

Credit

7,500.00

Cash

7,500.00

At the end of 2017, 1 month worth of rent has already expired. Prepaid Rent should be set-up for the remaining 2 months. The adjusting entry would be: Dec 31 Prepaid Rent

5,000.00

Rent Expense

5,000.00

At the beginning of 2018, the following reversing entry can be prepared: Date 2018

Particulars

Jan 1 Rent Expense Prepaid Rent

Debit

Credit

5,000.00 5,000.00

Again, notice that the adjusting entry is simple reversed. At the end of February, the entire rent paid has already expired. We do not need to make an entry here since we already prepared a reversing entry. Nonetheless, Rent Expense will be reviewed at the end of the year. Rent Expense and all other expenses will be checked to see if there are any unexpired portions which will require adjusting entries.